Most traders, when hearing the combination of trading and rate decision, have an immediate reaction. That is to avoid, avoid and one more time, avoid the situation.

If you are used to trading on technical indicators, then like most traders, a rate decision becomes your worst enemy. It’s a macro event that has deep fundamental connotations.

It can hit you like a black swan, and there is no technical indicator that can help you with that. So, the best idea would be to disengage, right? Well, not exactly. Here are a few tricks that I use that can step up your game on trading interest rates.

A Rate Decision is a Game of Chance

The first thing you have to realize with rate decisions (and, of course, I mean a Fed rate decision) is that it’s completely a game of chance.

No one really knows what will happen. And no indicator in the world can tell you with complete certainty what will happen. But you can have a good indication of what is expected and the market’s possible reaction. And that, really, is just enough. But unlike the conventional wisdom, the trick to playing this information is to go against the mainstream.

If a market is certain something is going to happen, in this case a rate hike, then it’s already positioned for it. That means your upside is high.

What if the market is caught off guard and gets a decision it didn’t expect? You could be drowned by a tsunami of traders is deep fear, eager to get out of their position.

So, if you went against the market consensus and bet on a rate hike it would have played out in one of two ways. If you were wrong, you’d think, oh well, it was already priced in. It was expected and your loss is minimal because the market was prepared for that decision.

Essentially, the move already took place, before you opened your trade. But if you were right and the consensus was wrong? There would be a tsunami, of course, but you would have been on top of it, potentially gaining big. In other words, you risked little for a potential big gain, a classic risk reward trading bet.

Your Tool Box

When it comes to rate decisions by the Fed, CME has the ultimate tool called FedWatch. The FedWatch essentially created a probability gauge for a Fed rate hike within a specific month. Let’s look at the probability level for a rate hike for September.

Yes, that’s the one where the Fed did not make a move. As you can see, the FedWatch tool indicated a 25% chance for a rate hike. That also means a 75% probability of no change. Now, as you can see in the chart below, as soon as the Fed announced its decision the Dollar index fell. But it fell by roughly 100 pips, hardly a hefty sell off.

Source: CME

In fact, support levels weren’t even broken at the time this article was written. Meaning? If you had taken the other side of the market consensus (with the 25% chance), you got it wrong. In the end, you got hit by 100 pips–ultimately, no big deal.

But what if the Fed had made a move? As you can see, the Dollar index was already close to its support levels. That means that traders were skeptical.

A fulfillment of the 25% chance would have caught the market off guard and would have resulted in a panic rally of the Dollar index. Get the idea? Of course this is relevant for all FX pairs related to the dollar such as the EUR\USD or the USD\JPY.

When It’s Not Worth It?

Of course, there are situations where it’s not worth it to engage. For example, if we move forward to January 16, you can see the market is pricing in a near 50/50 chance that the Fed will make a move. That means the market is not sure.

That means that Dollar index, or even any other Dollar pair, might swing either way. And that means it’s impossible to make an educated guess.

But what if the chances of a rate hike were higher than 60% and the Dollar was closer to its highs? A decision not to raise rates would have caught the market off guard. For a trader, it might have been wise to take a short position before the decision. Of course, there are many more layers and nuances that can be added which I will cover at another time.

Source: CME

In conclusion, there are no guarantees in life. But if you’ve ever wondered if you can step up your game on trading a rate decision, now you’ve got my two cents.

We ended the month in the black with a 0.74% return. I realize that nobody is jumping up and down with that kind of performance, but I’m honestly very excited to see the change.

At the beginning of October, I made a substantial change to the portfolio. Previously I attempted to pick pairs that were doing well. This approach was something of a mixed bag. While some periods of performance were quite nice, such as June of this year, the month of August was pretty harsh on the portfolio. I also didn’t like that the pair selection process was still very subjective.

The QB Pro strategy, like any strategy, makes its most important trading decisions when it selects its portfolio. The strategy is not one that can make money in any given environment. Instead, it requires careful selection of instruments in order to give itself the best possible opportunity to earn a profit.

The equity curve for the month of October 2015.

Based on about 100 hours of research with Jingwei back in September, I’ve been able to reduce the amount of discretion when selecting portfolio instruments. For example, the mega-monster performance from August 2014-March 2015 was driven exclusively by the strength of the US dollar.

As anyone who buys gasoline for their car knows, the trend shifted this year out of currencies and into commodities. Specifically, commodities have taken a real beating. China’s economy is sputtering, the US like it’s unable to raise interest rates and most industries suffer from serious gluts. Oil production in the US is widely rumored to possess a severe over-capacity, as evidenced by all the junk-debt ratings on US drillers. Gold mining stocks around the world have been the red-headed stepchild of financial markets, trading at PE ratios as low as 1.0.

That weakness spread to commodity currencies, even major currencies like AUD, CAD and NZD. As I ran backtests using a portfolios of those currencies and their crosses, I noticed that the equity curve more less marched straight up through the summer. More importantly, that basket of pairs benefited from the Chinese devaluation, whereas my custom basket took a step drawdown.

I’m expecting more problems of out both China and the US through the rest of the year. Although China managed to settle down after the summer, the problems plaguing it are anything but fixed. Recent bankruptcies and bailout of state owned firms point to more cockroaches. And, you know the rule about cockroaches. Where there’s one, there’s 10 more. I expect more Chinese devaluation to follow.

Lifetime equity curve of QB Pro’s high-risk version.

The commodity currency exposure is an indirect, systematic play on this expectation. The portfolio has done well in the current environment and, given that I don’t expect any improvement at all in China, should continue to do well.

The other variable is the Fed. I had the rather unfortunate luck of launching the portfolio just in time for a Fed governor to cast doubt on any US interest rate hikes this year. The change got off on the wrong foot. But QB Pro didn’t just stem the losses. It bounced off the equity low and marched upward in nearly a straight line for the rest of the month.

The Fed meeting in October forced the governors to pretend as though a 2015 rate hike is on the table. There’s always the chance that the Fed might hike rates just to prove a point. They’ve been talking about this for 9 months now. The futures market at one point put the odds somewhere near 67% for a 2015 rate hike. Prior to the meeting, those expectations fell under 25%, then jumped back to around 50%.

Even if the Fed did raise rates, I see an impossibly low probability of a sustained program of rate hikes. The data looks like a car sputtering on fumes. There’s deflation everywhere expect for the financial markets and beef, where “investors” have been encouraged to park their money in junk debt in exchange for a pitiful 4-5% yield. The economy is sick. The idea of consumers breaking out their wallets and spending like the drunken sailors of 2007 is laughable.

My expectation for the next 6-24 months is that the Fed slowly retreats from talk of hiking rates and into another round of QE. That will mark the final admission that the Keynesian policies aren’t working and where the markets lose all confidence in central banks.

A confidence collapse would slam currency markets, but it should exercise the most severe impact on the commodity currencies that my traders and I focus on with QB Pro. The deflation would press prices even further to the downside, which provides ideal conditions for this type of strategy.

Open slots for new traders

I’m hosting a webinar on November 12 to teach you as much as I can about algorithmic trading. The webinar is going to cover in detail the QB Pro strategy, especially the SB score. I’m also planning to discuss the Fed and Chinese situation in more detail, as these are the two most important factors for us to consider when applying strategies. Make sure to sign up to the newsletter to be notified when I start accepting registrations. This is also open to traders in the United States, which is a big change from previous options!

If you’re interested in trading the QB Pro strategy in your own account, attending the webinar will be mandatory. And as a thank you for spending 45 minutes of your day learning from me, you’ll be given a strong financial incentive to trade QB Pro. More details to come soon, so make sure that you subscribe to the newsletter now before you forget.

Back in the black! The return for the month was 1.03%. It’s not a huge gain, I concede, but a win is a win.

The lifetime equity for QB Pro

Performance didn’t really go anywhere this month. We floated 2% above and 2% below zero most of the time.

The QB Pro performance for September 2015 only

QB Yen came in again at a minor loss -0.61%.

The performance for QB Yen only, Sept. 2015

I’m a bit disappointed with the QB Yen performance so far. Nothing seems wrong other than bad timing turning it on on my part. It’s still hard to take it on the chin for 5 months running, though.

The hedge

I manually hedged the portfolio earlier this month by buying USDCNH in a pullback from of all the chaos. The portfolio took it hard when the yuan was loosened up. I figured that any further volatility would likely stem from USDCNH weakness.

The Chinese are actively intervening in their currency. As we all know from the GBP in the 1990s and the CHF this year, interventions work until they don’t. The main point of concern for me is the rollover cost. It is quite expensive to maintain the position.

The thing that makes me comfortable with that trade is that there is no chance of China miraculously healing. It’s in debt up to its eyeballs – everything from corporates all the way up to regional governments. And while China doesn’t want the yuan to devalue too quickly, the absolute last thing it would want is for the yuan to rise in value.

I cannot conceive of any plausible scenario where China manages to return to the 7-10% annual GDP growth that it experienced for 30 years. Too hot, too fast. If you have a plausible scenario in mind, then write your ideas in the comments section.

Updates to the strategy

I’ve promised many updates to the strategy over the past 6 months. Jingwei and I have evaluated them all. All of the proposed changes came up far short of my expectations and were thus not implemented in the live account.

I’m working with Jingwei, our actuary, to develop new trading systems. You’re going to learn the newest indicator in a few months.

The changes alluded to in the post are all different from QB Pro. I’ve flogged that strategy about as much as I can.

I feel good about QB Pro long term. Before anything potentially good happens in the account, however, I really need the Fed to get off the bench. Raising rates would be good for us because it should kick off a long term USD trend. Another round of QE would be the best thing for the strategy. I personally despise QE and think it’s a bad idea, but it would ignite a massive USD selloff. That’s the kind of market where QB Pro has done extraordinarily well in the past.

Here’s the US dollar index for the past year:

The US dollar index for the past year.

And for easy comparison, here’s the same QB Pro lifetime equity chart. Notice that performance peaked around mid-March and has been flat ever since.

The lifetime equity for QB Pro

Things should pick back up whenever the dollar picks a direction. I expect that to happen by year’s end. Nobody will believe the Fed if they punt one more time on a rate increase in December.

In the meantime, all of this research has given me the great epiphany that the strategy works best where pairs are trending. The portfolio is being rebalanced this month accordingly.